What the industry expects in 2007

High activity, high costs continue on UKCS

Professor Alexander Kemp, University of Aberdeen, Aberdeen, Scotland

This year has been one of high activity in the UK Continental Shelf (UKCS), with field development expenditures heading toward about $8.5 billion by year end and operating expenditures at a similar value. But these very high figures conceal part of the story. During 2006 cost escalation continued at a spanking pace – with one drilling rig contract attaining a $500,000 dayrate – affecting both investment and operating costs. Shortages of rigs continued and held up the drilling of interesting prospects. Priority was sometimes given to the drilling of incremental production projects to reap the benefits of high oil and gas prices. Continued shortages of skilled labor of all types resulted in substantial salary increases. For instance, the divers recently went on strike and achieved a settlement with a salary increase of no less than 44% over two years.

Oil and gas production declined in double digit percentage terms. These declines reflect a combination of natural depletion and shutdowns for maintenance and repair. The incremental production drilling should help moderate the decline rate in the mature fields.

Development drilling continued at high levels, and the year-end total should be around total of 227 wells, similar to 2005 levels. Exploration and appraisal drilling has been rather lower in 2006 than in 2005, but some significant discoveries have been made, notably in two blocks in the Central North Sea operated by ConocoPhillips and Talisman. A bright spot was the announcement by Chevron in November that a 3-well appraisal program of the Lochnagar/ Rosebank discovery off the West of Shetland was due to commence.

The year started with the effective introduction of an increase in taxation in the form of the Supplementary Charge to Corporation Tax being increased from 10 to 20% with the total becoming 50%. On older fields subject to Petroleum Revenue Tax, the rate became 75%. In principle, this can negatively impact field developments and exploration. Studies by the author indicate that at relatively high oil/gas prices, the effect on investment should be fairly moderate. At lower oil prices, investment will be significantly affected as the tax increase would have stronger effects. The system is entirely profit-related but many projects (new fields and incremental projects) involve quite small volumes and their financial materiality is very modest compared to those from larger fields in other petroleum provinces.

Adequacy of gas supply. There has been much concern regarding the adequacy of gas supply for the 2005 – 2006 winter. Wholesale prices spiked with forward market-values sometimes reaching astronomic levels. The UK market is becoming increasingly reliant on gas from imports and storage to meet peak demand. In late winter the Rough Field, which accounts for around 80% of storage capacity, encountered problems that forced it to close for a prolonged period. Had this happened in the early winter, the supply problem would have been much greater and spot prices would have reached even higher levels. The UK Government and regulator OFGEM have been well aware of the problem and the Department of Trade and Industry recently issued a consultation paper on Security of Gas Supply requesting comments on measures to enhance security of gas to the UK market.

Late in the year two new substantial pipelines to the UK opened, the Langeled line from Norway to Easington and the BBL line from the Netherlands to Bacton. Their combined capacity is substantial and has the potential to greatly increase UK supplies.

The prospects for 2007 are for a continuing high level of activity in the UKCS. Both field development and operating expenditures should at least equal the levels attained this year. Oil production should reverse recent trends and increase over 2006 levels. This is due in large part to the Buzzard field coming on stream in late 2006. The recoverable reserves of this field exceed 500 million bboe. Additional worthwhile projects are also slated to come on stream in 2007 with the net effect being to outweigh the declines from other fields for at least a year.

Gas production should continue its downward trend for some years to come, with no new major impetus to offset natural depletion from the older fields. In light of this outlook, the Government recently announced in the Energy Review the establishment of a joint working party with the industry to investigate the feasibility of developing an infrastructure to facilitate the development of gas discoveries from West of Shetland with reserves currently around 3 Tcf.

Challenging operating environment in 2007. The new fields currently being assessed for development are quite small with the average being only around 15 MMboe, with few exceeding 40 MMboe. Average lifetime development and operating costs exceed $15/boe with some being over $25/boe. Since oil companies traditionally adopt a very cautious view of oil prices to assess long-term investments, the expected returns are quite modest on an after-tax basis. If costs continue to escalate many projects will offer unexciting returns.

At the time of writing, the awards under the 24th Licensing Round were awaited. The number of applications was very high, explaining the delay in the awards’ announcement. The Government now puts on offer the maximum amount of available acreage in annual license rounds to help encourage activity. The “fallow initiative,” undertaken through PILOT, a joint Government/ industry body, has resulted in the acceleration of acreage being relinquished and re-offered to other investors.

The introduction of Promote Licenses is another initiative, which has resulted in a large number of blocks to very small companies who have two years of very low fees during which time to undertake geological/ geophysical studies. After this period, more substantial work programs have to be offered or the acreage has to be relinquished. While the take-up has been very high the results in terms of discoveries are still rather uncertain.

The gas market will remain tight for the 2006 – 2007 winter, but should see a significant increase in import capacity. The giant Ormen Lange field will commence production and send gas through the Langeled pipeline. Phase One of the South Hook LNG scheme as well as the Dragon LNG scheme will become operational during the year, while a substantial Isle of Grain LNG scheme is already in operation. There are fairly firm plans for further expansion of all these three projects in the period 2008-2010. The import capacity of the Interconnector between Zee-brugge and Bacton is also being expanded.

LNG and uncertain volumes. It is already clear that when all the potential imports are aggregated there will be ample capacity to supply the needs of the UK market on an annual basis. The planned increase in gas storage should also be adequate to supply peak winter demand. What is not so clear is the extent to which the LNG import capacity will be utilized since the LNG market is becoming increasingly international one and marginal supplies can be diverted to other more profitable markets. Thus, some uncertainty remains about the volumes of gas that will actually materialize in the UK market.

In this context considerable debate has already occurred on the continued positive price differential between the UK and the European continent last winter when the gas flow into the UK was far below the capacity of the Interconnector. The contractual terms between suppliers on the continent and their customers have been sited as the reason for this, and investigations by the regulatory authorities have to date not found overtly anti-competitive practices.

Taxation issues will continue to be debated in 2007. UKOOA, the operators’ association, has argued for tax incentives to facilitate further exploration and development. The Government has stated that there will be no further increases for the duration of the present Parliament. The debate will also involve the possibility of a major structural change, namely the abolition of Petroleum Revenue Tax (PRT). At first sight, the industry’s viewpoint on this might appear to be obvious. Investment in incremental projects in the fields liable to PRT would be encouraged. But the looming decommissioning problem involving large expenditures that are currently deductible for PRT makes the situation more complex. In this context, it should be noted that PRT applies only to fields developed prior to 16th March 1993. It will be difficult for the industry to have a unified stance on the subject.

Other issues regarding decommissioning will also feature in 2007, including the thorny issue of assuring financial security for decommissioning between licensees and the Government and among co-licensees. This issue may be inhibiting asset transactions involving mature fields in situations where the seller wishes to divert all liability for de-commissioning after the transaction is completed, but the Government has concerns about the ability of the buyer to meet these obligations.

Every year in the lifetime of the UKCS to date has been noteworthy with the outcomes including some surprises. Next year should be no different.

THE AUTHOR
	Alexander G. Kemp is the Schlumberger professor of petroleum economics at the University of Aberdeen. He previously worked for Shell, the University of Strathclyde and the University of Nairobi. For many years, Professor Kemp has specialized in petroleum economics research, with special emphasis on licensing and taxation. He has published more than 100 books and papers in this field, including Petroleum Rent Collection Around the World, Institute for Research on Public Policy (Canada). Professor Kemp is director of Aberdeen University Petroleum and Economic Consultants, providing consultancy in petroleum economics.